What is a Naked Debenture?

A debenture is a debt instrument issued by corporations and governments to raise funds. In the United States, a debenture that is not secured by any specific asset is called a naked debenture or uncovered debenture.

How Does a Naked Debenture Work?

In a naked debenture, the investor has the issuers promise of repayment of the interest and principal but has no claim on any specific collateral. If the issuer defaults, the debenture holders are to be considered as general creditors. The owners of naked debentures can claim the company's asset on the occasion of default, only after the investors whose securities are higher in the capital structure are paid their due. As a naked debenture is not backed by any physical asset or collateral, the debentures are considered to be covered by the full faith and credit of the issuer. So practically, it is a certificate of loan that ensures the company is liable to pay the stated amount with interest but that is not guaranteed by any collateral. The fund raised by debenture becomes a part of the company capital, but it doesn't become share capital. In the U.S., the government issues debentures in form of Treasury bonds or Treasury bills. The buyers buy these bonds based on the trust that the government wont fail to pay back the amount along with its interest. There are no collaterals involved in this. However, it is to be remembered that the U.S Treasury bills are considered to be one of the safest investments. Debentures are the most common form of long-term loans, taken by corporations with a fixed rate of interest and a fixed date of repayment. Usually, the corporations pay the interests of debentures before paying the dividends to its shareholders. The government and big corporations issue the naked debentures frequently to raise capital. As people have full confidence in the government and big corporations, they invest their money in such bonds. In the history of more than 200 years, the U.S. government has never failed to pay the scheduled interest or full principal upon maturity. Only the organizations and companies with a good reputation and strong economy issue the uncovered debentures. So, even without a collateral, the naked debentures are often more secure than the secured bonds. The issuing company signs an agreement with the trust that manages the interest of the prospective debenture holder for issuing debentures. The agreement is documented in an indenture.